Micro Focus International plc is a United Kingdom-based global software company. The Company is engaged in delivering and supporting software solutions. The Company enables customers to utilize new technology solutions while maximizing the value of their investments in information technology (IT) infrastructure and business applications.
Formed in 1976 Micro Focus has grown through several acquisitions and mergers. Micro Focus typically buys outdated software developers with minimum to no growth for reduced prices. They then cut the marketing, research, development and service.
This results in an immediate increase in profitability created by current cashflows and increases initial shareholder returns. This has been a successful model for the organisation since the turn of the millennium and is recognised as the firm’s growth strategy.
The organisation serves the most industries where IT plays a role in businesses. With over 40,000 customers globally it is considered one of the largest pure software organisations in existence with annual revenues of approximately $4 Billion.
Financial Statement Analysis
For the Financial analysis based on the Annual report of 2018 which consists of audited numbers for the 18-month period ending in October 31, 2018 compared to the previous period which was a 12-month period ending in April 30, 2017.
The financial analysis has been evaluated on parameters like Liquidity, Safety, Profitability, Efficiency, and Leverage. I have outlined the importance of each ratio.
(Refer to Appendix for Tables)
According to industry analysts Micro Focus profits for the current year, which will be reported in February 2020 are expected to fall by between 6 per cent and 8 per cent for the financial year ending October 2019.
The following analysis of four specific ratios has been carried out for the previous year 2018. The objective is to measure the company’s ability to generate a return on its resources and thus calculate the profitability of Micro Focus.
Gross Profit Margin – Indicates how well the company can generate a return at the gross profit level. It addresses three areas: inventory control, pricing, and production efficiency.(Hamid Moridipour1*, Zahra Mousavi2, n.d.)
Given the company is in the application software space, Gross profit margins are expected to be high, however the last 18-month period has shown a drop which is cause of concern. It could be a possibility of the merged entities reporting along with the mixture of product.
Another possibility is the industry transition to Software as a Service (SaaS). This model allows organisation to subscribe and consume as required. It supports organisations business models and allows for operational spend to be leveraged as opposed to capital expenditure.
Net Profit Margin – Shows how much net profit is derived from every dollar of total sales. It indicates how well the business has managed its operating expenses. It also can indicate whether the business is generating enough sales volume to cover its overheads and still leave an acceptable profit.
Looking at the net profit margin can give insights on whether the product is priced adequately to cover overhead expenses. If the product is priced too low, then sales revenues may not be enough to cover all of the other operating expenses.
Reducing margins at 8% are a call for concern.
However, It could be an outcome of the acquisition related costs or change in revenue models.
Return on Assets (ROA)–Support us in effectively evaluating the way in which a company employs its assets to generate a return. It measures efficiency.
ROA reported is rather low @ 4%. This emphasizes the need for renewed focus on improving profit margins and product margin mix and keeping a check on overheads.
Return on Equity (ROE) – ROE can be considered as profitability ratio from shareholder’s point of view. This provides how much returns on generated from shareholder’s investments, not from the overall company investments in assets.
ROE reported is reasonable @9%, however it depends on the expectations of the board and management.
An improvement of the previous cycle is a positive. Profitability of the company is the main stay here.
(Refer to Appendix for Tables)
We have done some analysis on Liquidity- ultimately this means the organisations ability to pay its debts as they arise.
We have leveraged four ratios to ensure accuracy as this is a key area to investigate. We have excluded Quick Ratio because inventory does not play a key role for Micro Focus. Being a software vendor where the key value is Intellectual Property, stock is not relevant.
Current Ratio – It gauges the ability a business is to pay current liabilities by using their current assets only.(Craig G. Johnson, 1970)
A general rule of thumb for the current ratio is 2 to 1 within the software space is considered healthy.
The current ratio maintained of 1.25x at the end of the 18-month period October 2018, indicates the company is covered paying its current liabilities. There is scope to improve this ration by primarily increasing sales and ensuring credit worthy customers.
Cash Ratio – This ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents. Cash ratio is useful for a company who is undergoing financial trouble. If the ratio is high, then it reflects underutilization of resources and if the ratio is low then it can lead to a problem in repayment of bills.
The cash ratio of 0.25x maintained is a relatively comfortable level.
Operating cash flow ratio – This measure of the number of times a company can pay off current liabilities with the cash generated in each period.
The company has maintained a cash ratio of 0.58x which is a relatively comfortable level, Efforts should be made to improve this over time with higher sales and improved gross margins.
Net Working Capital – A positive working capital is when the net working capital is a positive figure. This is a desirable situation for a company, specifically software and innovation driven organisations. Along with ensuring Micro Focus could stay competitive when required to innovate with cash when requires, it also ensuresit avoids bankruptcy.
If a company is in called negative working capital, the company may face liquidity issues and eventually lead to bankruptcy.
Micro Focus has maintained a positive working capital. Increase in Revenues while improving the margins and keeping a check on the receivables cycle would help keep the working capital in check.
For an investor this is a healthy liquidity to see. It is also expected within software organisations of this nature. Due to the nature of their organisations historic growth, acquisitions are key to their strategy; having a good liquidity ensures that they can continue to pursue this where required.(Mike Ashworth, n.d.)
(Refer to Appendix for Tables)
Evaluates how well the company manages its assets. Besides determining the value of the company’s assets, it also analyzes how effectively the company employs its assets.
Asset turnover ratio: This ratio is the relationship between the net sales of a company and total average assets a company holds over a period of time; this helps in deciding whether the company is creating enough revenues to make sure it is worth holding a heavy amount of assets under the company’s balance sheet.
As they are in the intellectual property business this ratio gives us good insight.
It indicates the relative efficiency with which managers have used the firm’s assets to generate output.
Here again, what is acceptable or appropriate varies. Usually, however, a higher ratio is better.
An Asset Turnover ratio of 28% is reasonable;
However it can be improved further with a focus on increasing sales volumes, as compared with other companies in the industry. The company needs to focus on improving its revenue generation or its revenue per employee, thereby utilizing the assets better.
Accounts Receivable Turnover – Shows the number of times accounts receivable are paid and re-established during the accounting period.
The higher the turnover, the faster the business is collecting its receivables and the more cash the company generally has on hand.
The company has maintained a Receivables Turnover of 3.74 which needs improvement, by focusing on faster payment from customers. Similar companies are having a higher Accounts Receivables to Turnover, which indicates that the credit policies need revamp or execution must be made more stringent while being more aggressive in ensuring receivables are realized faster.
Accounts Receivable Collection Period – Reveals how many days it takes to collect all accounts receivable.
The average collection period is a measure of both liquidity and performance. As a measure of liquidity, it tells how long it takes to convert accounts receivable into cash.
As a measure of performance, it indicates how well the company is managing the credit extended to customers.
The average collection period is over 95 days, which has a lot of scope for improvement..
The average receivables collection period across similar companies is nearly half that of the Micro Focus. Management and Sales team should implement strategies incentivizes customers to make quicker payments.
Accounts Payable Turnover – Shows how many times in one accounting period the companyrepays its accountsto creditors. A higher number may indicate either the business has decided to hold on to its money longer, or that it is having greater difficulty paying creditors.
Payables turnover ratio is rather low, indicating delayed payments resulting in interest implications. This has a cascading effect on delayed receipts from customers.
17 Payable Period – Shows how many days it takes to pay accounts payable. The business may be losing valuable creditor discounts by not paying promptly.
The Payables period is almost 300 days, which has declined further from the previous period. Cash inflows are lower resulting in delayed payments to vendors.
This may be a result of the adoption of the SaaS subscription models being offered to their customers.
Sales to Total Assets – Indicates how efficiently the company generates sales on each dollar of assets. A volume indicator, this ratio measures the ability of the company’s assets to generate sales.
The ratio is reasonable for a company of this nature. Improving the topline will improve this ratio further.
Leverage Financial Ratios
(Refer to Appendix for Tables)
Leverage financial ratios are used to evaluate a company’s debt levels.
Micro Focus’s most recent balance sheet shows liabilities of $3.93b due within the year, with liabilities of $6.23b which are due soon after that. Aside from these, the cash balance $2.67b. There is also receivables due which equate to $864.5m. These are due within 12 months.(Micro Focus, 2018)
So its liabilities outweigh the sum of its cash and (near-term) receivables by $6.63b.
Given the deficit is somewhat higher than the company’s market capitalization of $4.56b, We believe there is reason for concern from the shareholders and thus they should monitor the international debt of the company.
Common leverage ratios include the following:
Debt ratio: This measures the relative amount of a company’s assets that are provided from debt. (Lee Remmers, Arthur Stonehill, Richard Wright and Theo Beekhuisen, 1974)
The company has maintained a debt ratio of 0.54x, which is better than industry standards.(Micro Focus, 2018)
Debt to Equity ratio: The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity. This is important as ultimately your investment is equity.
The company has maintained a debt ratio of 1.15x which leaves substantial scope to leverage the equity.
Interest Coverage Ratio: The interest coverage ratio determines how easily a company can pay its interest expenses.
The company has barely managed to service the interest.
Debt Service Coverage Ratio: The debt service coverage ratio determines how easily a company can pay its debt obligations.
The company is not able to service its debt obligations. Company needs to work towards increasing revenues, margins and ensuring sustainable profits to be able to cater to its financial obligations to lenders.
There are limitations in the above ratios and in order for this to be more comprehensive a Debt to Asset ratio would need to be considered. This would show the strength of the organisation when looking to raise capital from loans.
(Refer to Appendix for Tables)
These ratios ultimately will show the returns previous years have brought. Investor ratios are used to measure the ability of a business to earn an adequate return for the owners of the business. The owners have money tied up in the business and need a return commensurate with the risk involved.
Earnings per Share Ratio (EPS): EPS ratio formula denotes how much market price you as an investor are paying for a portion of the earnings of the company.
The EPS is reasonable. It sits within the standard for organisations of this size in the technology sector.
Price-to-Book Ratio (P/B): Companies use the price-to-book ratio to compare an organisations market to book value by dividing the price per share by book value per share. (Frank E. Block, 2018)
A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company.(Frank E. Block, 2018)
Price-to-Earnings Ratio (P/E): PE ratio formula denotes how much market price an investor is paying for a portion of the earnings of the company.
Here the price has been considered as of the last day of the respective financial period. The PE ratio has dropped considerably from the previous period
Dividend Yield ratio: Dividend yields are the ratio of dividend paid out by the company to the current market price of the share of the company; this is one of the most important metrics in deciding whether an investment into the share will result in the expected returns.
The company has maintained a DYR in the region of 10% All the above Investor ratios indicate that the company needs to leverage its position to boosts revenues.
Due to the nature of Brexit and the potential impact this might have on Micro Focus being an British Headquartered organisation, precautions are being made to ensure operations are not affected. However, as the potential impact is still relatively unknown, Micro Focus have operating offices across Europe. This supports the organisation with flexibility on where revenue’s declared.
Software Market Economic Impact
According to Gartner the global software market spends, specifically on Enterprise software will increase by 9% in 2019 from 2018. This economically is positive for an organisation like Micro Focus.(Gartner, Inc. , 2019)
However, it is not all opportunity for Micro Focus, with legacy on premise software set to come to end of life as the adoption of cloud continues to be a focus for organisations.
The adoption of cloud technology has been both an opportunity and a risk for Micro Focus. The transition from a Capital Expenditure Model (CAPEX) to a more Operating Cost Model (OPEX).(Thomas Martin Knoll, 2014), (Armbrust, Michael, 2009)
This has meant the organisation has had to change the way in which they forecast and report on their financials. It also reduces the operating profit as cloud based subscriptions accrue more operating costs due to the management of the infrastructure and hosting services.
The benefit for the organisation implementing a subscription model for hosted services in theory means they can forecast ore effectively with a clearer view on predictable revenues. However this means there is more competition to retain customers and requires a more effective sales and operating model to ensure limited churn of customers.
The adoption of cloud has opened up many opportunities for smaller software providers in niche lines of business to challenge the larger organisations. Global communities of software practitioners can now collaborate effectively to bring products to market that challenge the larger organisations market share.
Due to this open source movement, we are seeing an increase in competition on legacy Micro Focus offerings along with an increase in the development of in house applications.
there are several questions to be asked about the leadership of Micro Focus. Executive Chairman Kevin Loosemore, a veteran in the software space has made some questionable decision over the last 24 months;
Most recent is his decision to sell of more than half of his shares for £11.6 million must be taken into consideration and is being deemed by analysts as a concern for investors.
CEO Stephen Murdoch has had questions asked around the levels of compensation he has received. His return to the helm of the organisation in 2017 saw an increase of salary of 66% which meant a £850,000 Salary. This is not uncommon and would be on the median side of salaries at the level, when you consider Oracle CEO SafraCatz earned $950,000 in 2018.(Ben Woods, 2019), ( DAVID LIEBERMAN and BRENT LANG, 2018)
With the actions of Kevin Loosemore over the past 12 months showing signs of potential profit losses, will be interesting to see what transpires over the next 12 months.
Rumours circulated by some analyst speak of sales of non-key software assets by the organisation which could see a large shift in executive leadership.
Recommendations and conclusions
Looking at the organisations current debt to cash reserves and the outlined factors in the above report, we would advise to tread carefully when investing in Micro Focus for both the short to long run.
The recent sale of the SuSe business has been a success in one sense that the organisation has been able to remove an asset that does not support the overall product stack, however we believe this is a sign of things to come.
The sale of future assets looks imminent and the shifts in leadership confidence does not bode well for the short term.
With net debt outweighing the cash reserves within the organisation there is reason for concern.
We would suggest limiting the percentage of your investment portfolio in this organisation. There are still potential returns to be had as we have outlined in the investment returns section of this report as historically shareholder value in a high priority for the organisation,. However the risks for us outweigh the opportunity.
Please feel free to reach out to us directly if you would require any more support and trading guidance.
Evaluation for Projects under consideration
With alignment on the request of management, to determine which project options would be the best opportunity for the business, I have compiled a report with my findings on the cost benefits of each of the three options.
We have gone through a process of Capital Budgeting by which management determine the value of a potential investment project.
We have used the three most common approaches to project selection which are- payback period (PB), internal rate of return (IRR) and net present value (NPV).
The Payback Period determines how long it would take Outdoors PLC to recover the original investment.
The Internal Rate Of Return is the expected return on a project. If the rate is higher than the cost of capital, it’s a good project. If not, then it’s not.
The Net Present Value shows how profitable a project will be versus alternatives and is perhaps the most effective of the three methods.
The Financial evaluation of the project options has given a split decision, with three of the parameters favouring Option A and one of the parameters favouring Option C.
The management ideally should take a suitable decision depending on the availability of funds and the duration of availability.
Here in this case, assuming the funds are available or can be financed, the company should invest to produce Greenhouse and Conservatories.
Outdoors Plc, is a company which produces a variety of high-quality garden furniture and associated items.
The management is evaluating opportunities to grow the company.
They are considering whether to invest in the potential to expand the business, the directors identifying three main options.
For successful implementation, each of the projects requires an upfront investment.
Assumptions made for financial evaluation:
CASH FLOW GENERATION
The estimated Cashflow to be generated from the each of the projects is provided in the respective tables below along with the projected investments which need to be made in Year 1. The following tables show the Net Cashflow positions for each option considered.
According to Priya, C 2019 – Capital budgeting is the method of determining and estimating the potential of long-term investment options involving enormous capital expenditure. It is all about the company’s strategic decision making, which acts as a milestone in the business. (Priya,C,2019)
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether the project will prove to be profitable.(Karim Bennouna, Geoffrey G. Meredith, Teresa Marchant, 2010)
The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection.
The payback period calculates the length of time required to recoup the original investment. A short PB period is preferred as it indicates that the project would “pay for itself” within a smaller time frame.(H. Martin Weingartner, 1969)
Payback periods are typically used when liquidity presents a major concern. As Outdoor PLC has a limited amount of funds, we might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. This is what we have scored as important due to the nature of the business.
Another major advantage of using the PB is that it is easy to calculate once the cash flow forecasts have been established. We can run this quite easily considering our expansion projects fall within our current operations.
There are drawbacks to using the PB metric to determine capital budgeting decisions. Firstly, the payback period does not account for the time value of money (TVM). Simply calculating the PB provides a metric which places the same emphasis on payments received in year one and year two. Such an error violates one of the fundamental principles of finance.
Internal Rate of Return
The internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with the discount rate – if the discount rate increases then future cash flows become more uncertain and thus become worthless in value – the benchmark for IRR calculations is the actual rate used by the firm to discount after-tax cash flows. An IRR which is higher than the weighted average cost of capital suggests that the capital project is a profitable endeavor and vice versa.(Joseph Hartman, 2014)
The IRR rule is as follows:
IRR > cost of capital = accept project
IRR < cost of capital = reject project
The best primary advantage of implementing the internal rate of return for decision-making is that it provides a benchmark figure for every project that can be assessed in reference to a company’s capital structure.
The IRR should consistently produce the same types or similar decisions as net present value models which in turn allows firms to compare projects based on returns on the invested capital.
Traditionally IRR is an easier model to use in finaincail calculators and in software solutions for financial management.
The downfall of using this metric is- the PB method, the IRR does not give a true sense of the value that a project will add to a firm – it simply provides a benchmark figure for what projects should be accepted based on the firm’s cost of capital.
The internal rate of return doesn’t allow for an effective appropriate comparison of mutually exclusive projects. Thus management might be able to determine that project A and project B are both beneficial to the firm, but they would not be able to decide which one is better if only one may be accepted.
The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those which are mutually exclusive. It provides a better valuation alternative to the PB method yet falls short on several key requirements.(Joseph Hartman, 2014)
Net Present Value
The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems.
Discounting the after-tax cash flows by the weighted average cost of capital allowed us to determine whether the projects will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives.
The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.(Stephen A. Ross, 1995)
Some of the major advantages of the NPV approach include its overall usefulness and that the NPV provides a direct measure of added profitability. It allows one to compare multiple mutually exclusive projects simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns. Although the NPV approach is subject to fair criticisms that the value-added figure does not factor in the overall magnitude of the project, the profitability index (PI), a metric derived from discounted cash flow calculations can easily fix this concern.
The profitability index is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 indicates that the NPV is positive while a PI of less than 1 indicates a negative NPV.
Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management’s preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantage associated with these widely used valuation methods.
The Bottom Line
Different businesses will use different valuation methods to either accept or reject capital budgeting projects. Although the NPV method is considered the favorable one among analysts, the IRR and PB methods are often used as well under certain circumstances. Managers can have the most confidence in their analysis when all three approaches indicate the same course of action.(Stephen A. Ross, 1995), (Joseph Hartman, 2014), (H. Martin Weingartner, 1969)
To the Initial cashflow (EBITDA) projected, in the Cashflow generation section, for each project, we factor in the Capital Allowances at 25% on a straight-line basis, over the 4-year evaluation period, to give us the Earning Before Tax (EBT).
The Corporate Tax of 12.5% is then applied to this which results in the Earnings After Tax (EAT), which here refers the Free Cashflow’s for the company.
The Free Cashflows generated over the 4-year evaluation period, discounted at the Cost of Capital (8%) gives us the Net Present value (NPV) of these futuristic cashflows.
The Free Cashflows generated over the 4-year evaluation period, discounted at the Cost of Capital (8%) gives us the Net Present value (NPV) of these futuristic cashflows.
Calculating the IRR, Profitability Index, and Payback Periods,
Outcome of the Financial Evaluation
- All the options have a Positive Net Present Value (NPV)
- All the options under evaluation provide higher return (IRR) than the cost of capital.
- All the options have a Positive Profitability Index
- All have payback ranging from 2 to 3 years.
- Option C has the best NPV of €37 million
- However, Option A provides the best IRR of 43.4%, and the highest Profitability Index of 1.93 with the lowest Payback Period of 2 years.
Taking a very objective look at the results, Option C would be better option, if the company has the investment amount (i.e. €2 million) freely available for 3 years.
However, if the funds available are limited (i.e. less than €2 million) or available for a shorter duration (less than 3 year), then the company could also look at Option A, with an investment of €0.75 million with a payback period of 2 years.
OPTIMAL INVESTMENT POLICY
- Funds are limited to €2,500,000
- Projects are divisible, (i.e. it is possible to undertake a fraction of a total project).
Here we have assumed that a project can be divisible into 25% parts
We can create 10 scenarios with varying degrees of project implementation (increments of 25%) capped within the €2.5 million budget.
Evaluating the NPV, IRR, Payback period and the Profitability Index, we arrive at the conclusion that Option 4 is Optimal Investment, from all parameters under evaluation.
Option 4, is combination of
100% of Option A – Expand Retail Outlets;
100% of Option B – Develop Internet Sales; and
25% of Option C – Produce Greenhouse & Conservatories.
The total project outlay is €2.45 million, which will generate an IRR of 37.4% with a payback in Year 3. The net present value of the future cashflows comes to €4.47 million with a profitability index of 1.82
SOURCES OF FINANCE
Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are used in different situations. They are classified based on time period, ownership and control, and their source of generation. It is ideal to evaluate each source of capital before opting for it.(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)
- Based on a time period, sources are classified as long-term, medium term, and short term.
- Ownership and control classify sources of finance into owned and borrowed capital.
- Internal sources and external sources are the two sources of generation of capital.
Given the payback period of the project options under consideration, we are looking for a medium-term financing, which could be:
- Preference Capital or Preference Shares
- Debenture / Bonds
- Medium Term Loans from
- Financial Institutes
- Government, and
- Commercial Banks
- Lease Finance
- Hire Purchase Finance
Owned capital also refers to equity. It is sourced from promoters of the company or from the general public by issuing new equity shares. Promoters start the business by bringing in the required money for a startup. Following are the sources of Owned Capital:
- Retained Earnings
- Convertible Debentures
- Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the company are not enough to satisfy financing requirements, the promoters have a choice of selecting ownership capital or non-ownership capital.
Certain advantages of equity capital are as follows:
- It is a long-term capital which means it stays permanently with the business.
- There is no burden of paying interest or instalments like borrowed capital. So, the risk of bankruptcy also reduces.
- Businesses in infancy stages prefer equity for this reason.
Borrowed or debt capital is the finance arranged from outside sources. These sources of debt financing include the following:(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)
- Financial institutions,
- Commercial banks or
- The general public in case of debentures
In this type of capital, the borrower has a charge on the assets of the business which means the company will pay the borrower by selling the assets in case of liquidation. Another feature of the borrowed fund is a regular payment of fixed interest and repayment of capital.(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)
Certain advantages of borrowing are as follows:
- There is no dilution in ownership and control of the business.
- The cost of borrowed funds is low since it is a deductible expense for taxation purpose which ends up saving on taxes for the company.
- It gives the business the benefit of leverage.
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